No. 62 November 2009

MERCATUS ON POLICY Potential Restrictions on Title Lending

By Todd Zywicki and Gabriel Okolski ne can hardly turn on a TV without seeing commercials in which cash-strapped indi- viduals bring their car titles to a lender for quick and easy . While auto title lend- ing may appear to be somewhat sketchy, it Ois actually a relatively safe and important source of credit for many Americans. However, current state legislation and a proposed federal rule seek to restrict this practice, with the very aim of protecting borrowers. This misguided paternalism will instead cut many people off from much- needed cash, encourage other, more dangerous lending practices, and potentially lead to other detrimental out- comes such as bounced checks or bankruptcy.

Car Title Lending as a Credit Vehicle Auto title lending grew out of traditional pawn shop operations, allowing borrowers to obtain larger loans by using one of their most valuable assets as . The amount of a car title varies; though some studies have found that lenders typically lend about 33 percent of the resale value of the automobile,1 others have documented loans of 50 to 100 percent of the car’s value.2 Most loans range from $250 to $1,000, although some are larger.3 This compares very favor- ably to a typical loan, for which the average value is $70.4 And unlike pawnbroker loans, the borrower is able to keep the asset against which she is borrowing.

Auto title loans also have highly transparent and easily under- stood pricing schemes. The only price point is the , and these loans generally do not involve up-front fees or prepayment charges. The (APR) on a title loan is typically 120–300 percent, depending on the amount borrowed.5 And while the borrower loses her vehicle in the case of default, the loan is usually non-recourse past that point, meaning that the borrower is not personally respon- sible for the debt. For example, if the car is not in operating

MERCATUS CENTER AT GEORGE MASON UNIVERSITY condition because of a mechanical breakdown or is resold for In addition to consumers outside of the traditional lending less than expected, the lender is still limited to channels, small, independent businesses rely on auto title and cannot sue the borrower for any deficiency. loans as an important source of short-term working capital. For example, a landscaping company may need several hun- dred dollars to purchase sod or bushes for a job or to meet Who is Using Title Lending? payroll expenses. The proprietor may pledge his pickup truck Auto title loans fall under the category of non-traditional to obtain the necessary capital to buy the supplies to com- lending products, which appeal to individuals who may not be plete the job. Then when the job is complete, the businessman able to obtain more formal lending products or need to obtain receives payment and can redeem the collateral. emergency cash quickly. Perhaps contrary to popular intu- ition, some title lending is used by moderate-income earn- ers who have enough wealth to own a car of sufficiently high Risks and Rewards value but who also have impaired credit. While borrowing against one’s car may seem to be an inherently dangerous practice, actual experiences with auto According to the American Association of Responsible Auto title lending have proven it to be a relatively reliable and sta- Lenders, the typical title loan customer for its members is 44 ble lending tool. Far from preying on low-income borrowers years old and has a household income of more than $50,000 who are unable to pay the loans back, title lenders seem to per year, but is excluded from traditional lenders such as be catering to a group of rational consumers who use this credit card companies, , credit unions, and small loan method as a means to obtain needed credit because theirs companies. In addition to these moderate-income borrow- has become impaired. ers, title loans also cater to lower-income consumers. A 1999 study analyzing data from the Illinois Title Loan Company For consumers who rely on these loans for essential needs, found that 37.6 percent of title loan customers earn less than the risks of outlawing title lending may outweigh the $30,000 per year, compared to 45.9 percent who earn more rewards. Although there is limited research on why con- than $40,000 per year. Additionally, approximately 46 per- sumers use title lending, research on other non-traditional cent of borrowers are repeat customers, and the average lending products (such as payday lending) is informative. loan duration is between three-and-a-half to four-and-a- A 2007 study found that 43 percent of custom- half months.6 ers had overdrawn their checking accounts at least once in the previous 12 months7 and primarily used funds for “bills, emergencies, food and groceries, and other debt service.”8 Research by two Federal Reserve economists found that Far from preying on low- when Georgia and North Carolina outlawed payday lend- ing, the incidences of bounced checks, consumer com- income borrowers who are plaints about debt collectors, and chapter 7 bankruptcy filings rose.9 Bounced checks and bankruptcy can be unable to pay the loans back, extremely detrimental to one’s credit and can carry higher title lenders seem to be costs than non-traditional lending products. Legislative bans on these lending options exchange a more-stable lend- catering to a group of rationa1 ing practice for practices that hurt low-income consumers. consumers who use this Industry sources report that about 14 to 17 percent of title method as a means to obtain loans default but that only about half of those (8 percent over- all) result in vehicle repossession.10 This high percentage of needed credit because theirs defaults that do not lead to repossession reflects the real- ity that many of the cars used as collateral tend to be older has become impaired. vehicles that often become damaged or break down over the course of the loan, limiting the incentives to expend the cost of repossession. Furthermore, according to the Ameri- can Association of Responsible Auto Lenders, more than 70 Title lending is especially attractive to customers without percent of its customers own two or more vehicles, making accounts and are a more attractive alternative than pawn repossession more of an inconvenience than a disaster. shop loans. Unlike pawn shop loans, title loans allow consum- ers to borrow larger sums of money, do not require borrowers As noted above, the alternative for many title loan borrowers to part with collateral, and do not require the transportation (specifically those who do not have bank accounts or credit of goods to the pawn shops. cards) is pawn shop loans. By way of comparison to title loan

2 MERCATUS ON POLICY NO. 62 novemBER 2009 default rates, one study found that 58 percent of all first-time Figure 1: Number of Title Lenders in Florida before and pawn shop loans default and only 37 percent are redeemed.11 after the imposition of interest rate ceilings in 2000 Another researcher found that default rates on all pawn shop 700 loans range from 13.9 percent to 30.2 percent.12

600 Effects of Legislation

Congress is considering two pieces of legislation that are 500 particularly threatening to non-traditional lending products like title pledge lending. The Protecting Consumers From Unreasonable Credit Rates Act of 2009, authored by Sen. 400 Richard Durbin (D-Il.), would place a flat interest cap of 36 percent on all consumer credit products. The House of Repre- 300 sentatives is also considering legislation to create a new Con- sumer Financial Protection Agency (CFPA) that would have Number of Auto Title Lenders Title Auto of Number unprecedented authority to determine the types of financial 200 products that consumers can choose.

From a broad perspective, regulations that impose caps 100 on interest rates for certain types of loans tend to result in term re-pricing, product substitution, and credit rationing. 0 Under term re-pricing, lenders offset limits of what they can Pre Legislation Post Legislation charge on regulated terms by increasing the price of other Source: Policis, The Effect of Interest Rate Controls in Other Countries, August terms of the loan or related loan products. Since the terms of 2004, 17, http://www.microfinancegateway.org/gm/document-1.9.26998/25620_ a title loan are relatively transparent, this may be difficult. file_The_effect_of_interest_rate_controls.pdf.

Instead, title loans may be more susceptible to product sub- friends and family, who may come from a similar demo- stitution, which arises when a particular consumer loan prod- graphic. The answer, therefore, for many may involve illegal uct cannot be priced to be made economically feasible. Each loan sharks and other dangerous avenues. This option is a very consumer ultimately desires to hold a certain amount of debt real consequence: A 2006 tightening of rate ceilings of con- based on income, saving preferences, and spending prefer- sumer loans in Japan has also been correlated with a dramatic ences. Restriction on auto title lending may force consum- growth in illegal loan sharking in that country, primarily run ers into a less-preferred mix of credit by eliminating some by organized crime.15 loans that title lenders were previously willing to offer. In some cases, this substitution may lead borrowers to riskier Furthermore, while policy makers may seek to limit auto title debt instruments. lending to reduce consumer over-indebtedness, the effects of term re-pricing and product substitution will simply shift con- Restrictive regulations could lead to a scenario of credit sumers to a different mix of terms (such as lower interest rates rationing, in which lenders limit their supply of loans because but higher up-front costs) or different, higher-cost products. it becomes economically impossible to make loans consistent In fact, one report concludes that interest-rate ceilings may with the regulation. In this case, it becomes impossible for exacerbate over-indebtedness by resulting in increased loan certain borrowers to obtain formal credit, leading some bor- sizes and increased use of longer-term installment debt, which rowers to turn to friends and family or illegal loan sharks or locks borrowers into less-flexible debt arrangements.16 to do without credit altogether.

A prime example of these adverse effects occurred in Florida, Conclusion which was one of the earliest states to adopt title lending. In American citizens and businesses rely on title loans for 2000, however, the state imposed severe interest rate ceilings financial security and stability, and lenders are made up of on title loans.13 The number of auto title lenders operating in a broad mix of Americans, each with unique risk and incen- the state dropped severely, from 600 to 58 (see figure 1).14 And tives. One-size-fits-all regulation is likely to be maladapted to as mentioned above, such limitations may lead to a dangerous each of these groups and will only hurt the consumers they rise in bankruptcies and bounced checks. are trying to help. The bottom line is that restrictions on auto- title lending will eliminate an important funding option for If auto title loans are severely constrained, low-income con- many consumers, especially those of lower income, and will sumers may be limited in their availability to borrow from incentivize the use of more risky or dangerous credit chan-

MERCATUS CENTER AT GEORGE MASON UNIVERSITY 3 12. John P. Caskey, “Pawnbroking in America: The Economics of a Forgotten nels. Auto title loans have proven themselves to be reliable Credit Market,” Journal of Money, Credit, & Banking 23, no. 1 (1991), and useful in the past; policy makers should weigh these low 90. risks with the high benefits of this type of lending in making decisions for the future. 13. Quester and Fox, Car Title Lending: Driving Borrowers to Financial Ruin, 10.

14. Policis, The Effect of Interest Rate Controls in Other Countries (London: Endnotes August 2004), 17, http://www.microfinancegateway.org/gm/docu- ment-1.9.26998/25620_file_The_effect_of_interest_rate_controls. 1. Tom Feltner, Debt Detour: The Automobile Title Lending Industry in Illi- pdf. nois, Woodstock Institute and the Public Action Foundation, September 2007, 8, https://www.policyarchive.org/handle/10207/18300. 15. Policis, Economic and Social Risks of Consumer Credit Market Regula- tion: A Comparative Analysis of the Regulatory and Consumer Protec- 2. Jean Ann Fox and Elizabeth Guy, Driven into Debt: CFA Car Title Loan tion Frameworks for Consumer Credit in France, Germany, and the UK Store and Online Survey, Consumer Federation of America, Novem- (London: 2006), 47–49. ber 2005, 11, http://www.consumerfed.org/pdfs/Car_Title_Loan_ Report_111705.pdf. 16. Ibid., 74, 78. 3. Tennessee Department of Financial Institutions, The 2008 Report on the Title Pledge Industry, February 20, 2008, 4, http://www.state.tn.us/tdfi/ compliance/tpl/TPLReport2008FinalFinal.pdf.

4. Paige Marta Skiba and Jeremy Tobacman, “Measuring the Individual- Level Effects of Access to Credit: Evidence from Payday Loans,” (working paper, Vanderbilt University Law School and University of Oxford, July 3, 2007); see also Robert W. Johnson and Dixie P. Johnson, Pawnbrok- ing in the U.S.: A Profile of Customers, Credit Research Center Mono- graph No. 34, 1998, 16; John P. Caskey, Fringe Banking: Check-Cashing Outlets, Pawnshops and the Poor (New York: Russell Sage Foundation, 1994), 44.

5. Figure based on personal conversations with members of the Ameri- can Association of Responsible Auto Lenders. See also Michael S. Barr, “Banking the Poor,” Yale Journal on Regulation 21, no. 121 (2004): 166 (reporting range of 264–300 percent APR for title loans); Amanda Quester and Jean Ann Fox, Car Title Lending: Driving Borrowers to The Mercatus Center at George Mason ­University Financial Ruin, The Center for Responsible Lending and The Consumer is a research, education, and outreach organization Federation of America, April 14, 2005, http://www.responsiblelending. that works with scholars, policy ­experts, and govern- org/other-consumer-loans/car-title-loans/rr008-Car_Title_Lending- ment officials to connect­academic learning and real- 0405.pdf (listing average APRs of 183–377 percent in survey of several world practice. states); Tom Feltner and Sara Duda, Beyond Payday Loans: Consumer Installment Lending in Illinois, Woodstock Institute, March 2009 (256 percent APR in Illinois). The mission of Mercatus is to promote sound ­inter­disciplinary research and application in the 6. Illinois Department of Financial Institutions, Short Term Lending: Final ­humane sciences that integrates theory and ­practice Report, 1999, http://www.idfpr.com/dfi/ccd/pdfs /Shorterm.pdf. to ­produce solutions that advance in a sustainable 7. Gregory Elliehausen, An Analysis of Consumers’ Use of Payday Loans, way a free, prosperous, and civil ­society. Financial Services Research Program Monograph no. 43, January 2009, 35.

8. Jonathan Zinman, “Restricting Consumer Credit Access: Household Sur- vey Evidence on Effects around the Oregon Rate Cap,” (working paper, Dartmouth College, December 2008), 9, http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=1335438. Todd Zywicki is a senior scholar with the Mercatus 9. Donald R. Morgan and Michael R. Strain, Payday Holiday: How House- holds Fare after Payday Credit Bans, Federal Reserve Bank of New York Center, professor of law at George Mason University Staff Report no. 309, Feb. 2008. School of Law, and a senior fellow with the James Buchanan Center, George Mason University. 10. Tennessee Department of Financial Institutions, The 2008 Report on the Title Pledge Industry (reporting 17.5 percent charge-off rate as measured Gabriel Okolski is a graduate fellow with the Mer- in dollar amount). catus Center and an MA student in economics at 11. Skiba and Tobacman, “Measuring the Individual-Level Effects of Access George Mason University. He works with the Regula- to Credit: Evidence from Payday Loans.” tory Studies Program on issues related to state fiscal transparency and government accountability.

4 MERCATUS ON POLICY NO. 62 november 2009